Europe’s manoeuvring could spark a currency war

A higher euro could make the ECB’s task in fighting off abnormally low inflation tougher.
Photo: Bloomberg

by
Vesna Poljak

The European Central Bank’s blockbuster June policy meeting could stoke debate over the currency wars again if policymakers can engineer a lower-value euro.

While a favourable currency outcome for the ECB is no guarantee – indeed experts say the market could be counting on too aggressive a response in Brussels and risks being disappointed – a declining euro could pressure other central banks to act.

The currency wars were fuelled by the quantitative easing strategies developed by the United States Federal Reserve which are now being unwound, having peaked at $US85 billion a month. But a return to stimulus for Europe could set off a chain of events that upsets the period of abnormal volatility that has characterised markets this quarter.

HSBC foreign exchange strategist Paul Mackel said the reaction from other central banks was critical.

“The theme seems to ebb and flow although I’d say the risks are rising that it becomes a more dominant theme for the FX market should the ECB do something aggressive.

“We can’t lose sight of the idea that when these unconventional measures are announced it’s going to be very uncomfortable for those that are going to bear that burden."

Mr Mackel, who co-authored HSBC’s high-profile currency wars report last year, added: “We’ll be keeping very close tabs on what central banks and other officials are doing."

The Bank of Japan’s response could be the most significant. The BoJ is still in with a chance of accelerating its bond purchases this year beyond the current annual pace of ¥60 trillion to ¥70 trillion ($750 billion) and faces undesirable yen appreciation if the euro falls.

Related Quotes

Company Profile

The currency wars went all the way to Russia’s Group of 20 meeting in February 2013, where an agreement to strike a truce was nailed out. G20 finance ministers agreed to refrain from competitive devaluation, a practice that has come to be known as the race to the bottom. The impact was most serious for emerging markets.

Headaches for the RBA

The Fed’s QE created a headache for the Reserve Bank of Australia by stirring interest in the Australian dollar which has stayed high ever since as the greenback fails to respond to the tapering of QE. It was fetching US92.83¢ on Thursday hours before the ECB was due to sit down.

Mr Mackel theorised that a sharp reaction in currency markets could prompt the RBA into jawboning again.

“The capacity for it to come back is still very, very high.

“The RBA has not used the uncomfortably high phrase but I think they would be pretty quick to re-use that phrase should they feel it’s necessary," he said.

In its policy statement on Tuesday the RBA referred to the currency as “high by historical standards".

Commonwealth Bank of Australia chief currency and rates strategist Richard Grace suspected the euro would probably rise in the wake of the ECB meeting, highlighting the years of recovery ahead for the region.

“I tend to think that the central banks conduct monetary policy in order to meet inflation targets not to influence the currency," he said.

“I actually think euro will go up if they deliver what the market is expecting. I think they would have to surprise the market with a greater amount of QE and cuts to the official rate if they want the euro to go lower."

Mr Grace cautioned a higher euro could make the ECB’s task in fighting off abnormally low inflation tougher.

“The only problem is that it provides a headwind to their objective of higher inflation, that’s all it does."

“It’s really got to do with the impact of the exchange rate on inflation. While [ECB president Mario] Draghi has indicated further appreciation of the euro dampens inflation and upsets the outlook for achieving their inflation objective, there’s not a lot they can do to control it."

Mr Grace said that the previous two ECB rate cuts in the past 12 months had coincided with a higher euro.